Corporate Governance

It?s a Wonderful Lie: Mutual Fund Advocacy for Shareholders? Rights, part 2

By Jennifer S. Taub

Mutual funds benefit market participants differently. For direct shareholders who hold shares through the retail or intermediary channel, and for indirect shareholders who hold fund shares through a retirement plan, benefits include the ability to invest a relatively small amount of money and yet have access to the expertise of professional money managers. Individual shareholders also benefit from achieving a diverse portfolio of securities that would otherwise be difficult to hold efficiently given the small amount of dollars invested.

Just as mutual funds present positive benefits to market participants and the market generally, they also have their detriments. At one end of the spectrum are those who consider actively managed mutual funds to be a bad deal for customers. Illinois Senator Peter G. Fitzgerald (R) challenged the entire structure of the industry: '[T]he governance structure of a typical mutual fund is a study in institutionalized conflict of interest. Until we eliminate the conflicts, many mutual funds will continue to engage in behavior that benefits fund managers at the expense of fund shareholders.'

Some critics suggest that individuals are better served by an index fund that would have lower expenses. Given that even the most successful money managers have difficulty beating the market by more than 1%–2% each year, critics believe that most actively managed funds will be able to beat an index only if such funds have extremely low expenses. According to these critics, the top 20% of equity mutual funds with the highest expenses charged an average of 1.85% more than the 20% with the lowest expenses. However, those top funds earned 1.91% less. Stated in more stark terms, according to Jack Bogle, founder of Vanguard and former CEO, an investment of $10,000 for the 20-year period beginning 1985 and ending 2005 would return a profit of $109,800 if invested in the S&P 500 index. In contrast, that same $10,000 investment would produce just $62,900 in profit if invested in an average actively managed fund.

Pooling of assets through mutual funds creates mutual fund investors who are indirect owners. Being an owner of a public company carries a bundle of rights and expectations including the right to vote at annual or special meetings. This shareholder franchise though, is a limited one, even for direct shareholders. A mutual fund that pools assets also pools voting rights. The mutual fund customer loses the ability to vote those shares in the portfolio company. Those voting rights get aggregated with other mutual fund owners' rights.  

Another cost to mutual fund investment is lost advocacy beyond the voting context. Unlike a direct shareholder, a fund shareholder may not introduce a shareholder resolution in a portfolio company's proxy materials. In addition, a mutual fund customer may not participate in a securities class action settlement. Instead, mutual fund customers rely upon the mutual fund to collect settlement amounts on behalf of the funds. A recent lawsuit contends that mutual funds have left millions, if not billions, of dollars 'on the table' for failing to file notice of claims in class action lawsuits. In January of 2005, more than 40 mutual fund managers were sued for failing to file claims in securities class action settlements. According to the allegations, up to $2 billion of settlement payments were left unclaimed.

Adapted from: 'Able but Not Willing: The Failure of Mutual Fund Advisors to Advocate for Shareholders' Rights,' Journal of Corporation Law, Vol. 34, Issue 3 (2009).

Full post as published by The Race to the Bottom on August 17, 2009 (boomark / email).